Why inflation is not the big problem

Soaring food and energy costs are painful, but falling home prices could mean even bigger worries.

(Fortune) -- Suddenly inflation is the word on everyone's lips. But as much as they might like to, policymakers cannot forget about a bigger problem - the lingering effects of the
credit crunch.

With food and energy prices soaring, central bankers on both sides of the Atlantic are making hawkish noises about inflation. "Inflation rates are expected to remain high for a rather
protracted period of time before gradually declining again," European Central Bank President Jean-Claude Trichet said at a press conference Thursday after the ECB held its key rate
steady at 4%. The comments came two days after Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, warned in a speech of "a significant risk that higher inflation
will become embedded in the economy and require significant monetary policy tightening to reduce it."

The comments, which hold the implicit threat of inflation-quelling rate increases, come at a time when worries about the financial market crisis that started last summer are on the
wane. Stock and bond markets have staged a modest rebound since the Bear Stearns (BSC,
Fortune 500) panic of almost two months ago, and observers including
Berkshire Hathaway (BRKA, Fortune 500) chief Warren Buffett and Treasury Secretary Hank Paulson have
indicated they believe the acute stage of the mortgage mess may have passed. With the prices of milk and gasoline approaching $4 a gallon in the U.S., inflation is now competing with
recession as the hot-button word.

But as painful as higher prices are for consumers, there's reason to believe that economic weakness will be the heftier burden for the economy as the year goes on. Even if financial
firms avoid another crisis along the lines of the near-meltdowns earlier this year of Bear Stearns and Countrywide (CFC, Fortune 500), some economists say problems in the financial sector are only
beginning to be felt on Main Street.

"The real economy hasn't yet taken the hit," says Northern Trust economist Asha Bangalore. She says she expects unemployment, recently at 5% after falling into the low 4% range in the
housing-fueled economic expansion earlier this decade, to rise to 6% before the current slowdown ends.

Bangalore points to Monday's release of the Fed's Senior Loan Officer Opinion survey, which showed tightening standards for all sorts of consumer and commercial loans. "The net
fractions of domestic banks reporting tighter lending standards were close to, or above, historical highs for nearly all loan categories in the survey," the Fed said. That means less
money is going into the economy to feed consumer spending and business expansion.

Even as lenders tighten their purse strings, Bangalore says Federal Reserve officials aren't inclined to resume cutting rates. Instead, they want to see how the rate cuts they have
already enacted - the Fed has cut its fed funds overnight lending target to 2% from 5.25% since Labor Day - affect the economy. Interest rate changes take some six to nine months to
show an effect on economic growth, economists say.

"The Fed is not likely to do much in coming months," says Bangalore. "Right now, it's a watching game."

One set of statistics everyone is watching is the numbers coming from the housing sector. Len Blum, an investment banker at Westwood Capital in New York, says he doesn't expect to see
economic growth recover until the housing sector returns to normal.

Home starts and house prices have dropped sharply in recent months, but inventories of existing houses for sale remain bloated, suggesting prices will have to fall further, he says.
Executives at Fannie Mae (FNM, Fortune 500) said this week they expect house prices to drop 15%-19% peak to
trough, including a 7%-9% decline this year.

While falling house prices are good for prospective home buyers and necessary if the markets are to clear, a steep drop stands to create problems of its own. Fannie Mae this week set
plans to raise $6 billion in new money and cut its quarterly dividend to give the firm enough capital to head into what CEO Dan Mudd called "the belly of this cycle." The head of
Fannie's regulator, James Lockhart of the Office of Federal Housing Enterprise Oversight, told CNNMoney that he believes the new capital will be enough to see Fannie through a 10%
decline in housing prices from current levels.

But Blum says there are plenty of reasons to remain skeptical about Fannie and its government-sponsored sibling Freddie Mac (FRE, Fortune 500). While a 10% drop in house prices sounds severe, it's easy to see
how prices could fall even further if a recession leads to rising job losses - a trend that could send defaults even higher.

Blum also notes the companies' thin equity cushions - losses of just 5% on the firms' massive mortgage portfolios could wipe out shareholders - and the accounting problems earlier
this decade that resulted in regulatory capital-surplus rules that are only now being rolled back. "There are lots of ifs with these companies," he says. "Their track records aren't
especially good."

Like Bangalore, Blum believes inflation is likely to moderate on its own in coming months, as the economy suffers through a recession tied to declining consumer spending and job
losses. He says the weak position of workers - due to declining union membership and job outsourcing - will prevent wages from spiraling out of control. Blum says the bigger problem
stems from the weakness in the economy, for which there is no sign of an antidote.

"There is no pleasant way out of this," Bangalore says. "We have to live with it."